Short Selling
Shorting a stock involves selling a stock that an investor does not hold in the expectation that it can be bought back at a later date at a lower price. This provides a way to make absolute returns when stock prices are falling. Custodian banks act as facilitators to this process. Custodian banks approach their fund management clients to make stock lending agreements. Stock lending provides a means for fund managers to enhance returns, they lend the stock to the short seller, but retain all of their rights to the stock (dividends, rights issues etc.). In return the short seller pays a fee for this facility.
The custodian bank is exposed to counterparty risk and will also require a margin deposit from the short seller. The short seller sells the borrowed stock into the market. The proceeds from the sale cover the margin requirement and fees and leave a balance that can be invested elsewhere, usually in the money market.
Closing a short position requires a reversal of these flows. The short seller withdraws their money market deposit, buys back the borrowed stock in the market, returns the stock to the custodian bank and receives back its margin deposit.
Tags: Business, credits, loans, Short Selling
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